Proposed Rule

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EXPLANATION OF PROPOSED AMENDMENTS

On July 21, 2003, the Commission adopted a core principle approach to CTA performance reporting for partially-funded accounts. The core principle - which is codified in CFTC Rule 4.35(a)(7) - states that CTAs may present the performance of partially-funded accounts in any manner that is balanced and does not violate the antifraud provisions of the CEA or CFTC regulations. The preamble in the adopting release voices strong support for using the nominal account size when calculating ROR for partially-funded accounts, but the rule does not require it.

NFA and the industry believe that CTAs should use a uniform performance calculation so that clients can compare the performance of different managers and funds more easily. The July 21, 2003 release acknowledges these comments and states that the CFTC's core principle approach would not preclude the development of more explicit guidance or performance standards by self-regulatory organizations.

NFA's proposal provides uniform performance standards for Member CTAs and requires certain disclosures to ensure that clients understand the consequences of partially funding their accounts. This proposal was developed with the help of an informal subgroup of industry representatives.

Proposed NFA Compliance Rule 2-34 contains four sections. Section (a) requires CTAs to calculate ROR - including drawdown information - based on nominal account size. It also allows CTAs to include interest earned on actual funds in their performance calculations. An amendment to Compliance Rule 1-1 adds several definitions, including those for the terms "nominal account size" and "actual funds." In particular, "nominal account size" is defined as the account size agreed to by the client that establishes the level of trading in that program, and "actual funds" is defined as the equity in the account plus funds that can be transferred to the account without the client's consent to each transfer (known in the industry as "committed funds").

Section (b) of the proposed rule requires a written confirmation for each partially funded account. This confirmation must contain the name or description of the trading program and the nominal account size agreed to by the client and the CTA, and it must be updated whenever that information changes.

Section (c) of the proposed rule requires CTAs to provide certain disclosures designed to ensure that clients understand the consequences of partially funding their accounts. For example, among other items, CTAs must provide a description, by example or formula, of the effect of partial funding on rate of return and drawdown percentages. The disclosures do not have to be given to clients with fully-funded accounts or to qualified eligible persons.

The final section of the rule requires CPOs to report CTA performance on the same basis that the CTA is required to report it. This will ensure that the performance reported in a commodity pool disclosure document is the same as the performance reported in the CTA's disclosure document.

The proposed Interpretive Notice further explains the requirements in Compliance Rule 2-34. The four sections of the Interpretive Notice are summarized below.

• The section on "Documenting the Nominal Account Size" describes how the written confirmation can be given and provides the CTA with flexibility in complying with the confirmation requirement.
  
• The section on "Disclosure" provides examples of the type and manner of acceptable disclosure.
  
• The section on "Actual Funds" provides a test for determining whether funds that are not in the trading account will qualify as actual funds. This test is based on the test for "committed funds" in CFTC Advisory 87-2 and should allow the CFTC to rescind that Advisory.
  
• The section on "Materiality Standards" provides a materiality test for determining whether accounts can be included in the same performance capsule. This test is based on the materiality standards in CFTC Advisory 93-13 and a 1991 release regarding additions and withdrawals. As you are aware, the CFTC has already rescinded the 1991 release, and we believe that including the materiality test in NFA's Interpretive Notice should allow the CFTC to rescind Advisory 93-13 as well.

The introduction to the proposed Interpretive Notice states that CTAs will not be required to restate their previous performance. This means that they will not be required to recalculate performance that was calculated using one of the current methods. If the calculations produce significantly different results, however, the CTA should disclose the difference and explain the reason for it.

Compliance Rule 2-29(b)(5) has been amended to conform to the provisions of new Compliance Rule 2-34. Additionally, Compliance Rule 1-1 has been amended to add four new definitions.

NFA intends to implement NFA Compliance Rule 2-34 and its interpretive notice on the first day of the fourth month after the CFTC approves it or determines not to take review. This will give Members a minimum of three months to come into compliance. The confirmation requirements in NFA Compliance Rule 2-34(b) will apply to all existing accounts and the disclosure requirements in Compliance Rule 2-34(c) will apply to all accounts opened on or after the effective date of the rule. The performance requirements in NFA Compliance Rule 2-34(a) and (d) will be effective for all disclosure documents as of the effective date of the rule.

As mentioned earlier, NFA is invoking the "ten-day" provision of Section 17(j) of the Commodity Exchange Act and will make the proposals contained herein effective on May 1, 2004 unless the Commission notifies NFA that the Commission has determined to review the proposals for approval.